Webb-site Reports

Season's greetings to all our readers - and that means it's time for our annual stock pick. Once a year, we rummage in our sack of small-cap investments for the stock we think is most likely to perform over the next year. For the last 3 years, the compound return on our picks has been 195.2% while the Hang Seng Index made a loss of 29.1%. So what's are we putting under the Christmas tree this year? Read on...

The 2002 Christmas Pick
4 December 2002

Webb-site.com has been running four years now, and loyal readers will know that we only give one gratuitous stock pick per year - something nice to say in the season of goodwill to make up for write-offs of corporate malfeasance in the rest of the year. We rummage in our sack of investments and pick the stock from our portfolio that we think is most likely to perform over the next year - our money is where our mouth is.

Before we tell you what we've picked this year, first we'll do something you seldom see the professional analysts do - look back at how our first three recommendations performed. Prepare to be amazed (well, we were). Yes, it's true. Even in Hong Kong, you can make money in stocks.

2001's Pick

Last year's pick on 3-Dec-01 was Tungtex (Holdings) Co Ltd (Tungtex, 0518), which closed that day (before publication) at $1.43. Well, a big round of mince pies and sherry for Benson Tung and his team - a year later, it closed at $2.05, having paid out $0.185 in dividends, for a total return of 56.3%.

At roughly the same time, the Hang Seng Index, including reinvestment of dividends, lost 7.9% during the 12 months to 30-Nov-02 (we only have monthly data). So if you put $1,000 in the HSI on 30-Nov-01, then a year later you had $921. If you put $1,000 in Tungtex, then you'd have $1,563. So Tungtex out-performed the HSI by 69.7%.

During the spring and early summer, HK experienced something of a renaissance in small-caps, cooling off as the summer wore on. The stock reached a high of $2.50 on 17-May-02.

We still hold the stock, and have urged the board to distribute some of the surplus cash, since they are making it faster than they can invest it in new factories and shops. As of 31-Mar-02, the company had net cash of HK$318.0m, or about $0.90 per share. Since then, they've paid dividends but these are probably covered by cash earnings. They are now earning virtually no interest on that money (call it $0.01 per annum), so distributing some of it would barely effect earnings per share. The historic reported P/E (31-Mar-02) is 8.2x, but excluding the cash, the core P/E (on the core business) is only about 4.8x.

Distributing surplus cash returns capital to investors who can use it more efficiently, and boosts return on equity. Surplus cash in a controlled company always receives a discount to its actual value, for uncertainty over what management may do with it.

Tungtex is a play on the US consumer recovery. A London marketing office was set up to help diversify revenues to Europe, and the company is also developing its Chinese retail business which should bring contributions in the long term.

2000's Pick

On 4-Dec-00 we picked Kingmaker Footwear Holdings Ltd (1170), which showed a robust first-year return of 53.2% compared with a 17.1% negative return in the HSI from 30-Nov-00 to 30-Nov-01.

Last year we said we still liked the stock, flagging the strong balance sheet and the factory expansion plan in China and Vietnam. The stock closed at $1.52 on 3-Dec-01, and a year later stood at $1.99, having paid out $0.13 in dividends, for a total return of 39.5%. Compound that with the previous year, and they've returned 113.7% in two years.

The stock reached a high of $2.70 on 4-Jul-02. We still hold the stock, and while we can't expect the same kind of return in the next two years as the last two, so long as people are walking, they will need shoes, and Kingmaker is very focussed on making more of them.

1999's pick

Three years ago, IMI Global Holdings Ltd (then Boto International Holdings Ltd, Boto, 0585) was our first Christmas pick, and last year we wrote the following:

"The stock still only trades on about 6.8x historic earnings and we estimate 20% earnings growth to Mar-02 making the prospective p/e around 5.7x, but we've probably seen the best of the returns for now, and the fiddling with technology investments necessitates a continuing discount for the risk of 'accidents'."

That proved to be a prescient warning. As regular readers will now know, in April Boto announced plans to sell its entire core festive products and garden furniture business, accounting for 100% of its turnover, to a management buy-out vehicle for no effective premium, leaving Boto with a start-up animation business.

We fought against this proposal, which was eventually modified to leave Boto with a 25% contingent stake in its former core business (subject to dilution by management options). We still fought against the sale. We won't repeat the long saga in this article - you can find it all in our story index. The proposal was passed 53% to 47% in a shareholders' meeting, but only after the Stock Exchange allowed various management-related shareholders to stack the vote - the public shareholders were overwhelmingly against it.

Still, for the record, Boto returned our readers 81.6% in its first two years to 3-Dec-01, while the HSI returned a negative 22.9%. The price on 3-Dec-01 was $0.315. Since then, the stock paid a dividend of $0.007 and a special dividend (of the sale proceeds) of $0.26 per share, and when the deal which transformed the company was completed on 4-Sep-02, the shares closed at $0.043, for a total take-away of $0.31. So we managed to preserve our returns, even though the upside of the core business was stripped away. Boto is now history.

Summary of returns

So how are we doing so far? Here's the track record of the Webb-site.com Christmas Picks:

Pick date	Stock	Stock 1-year return	HSI 1-year return	Stock 2-year return
3-Dec-99	Boto	23.3%	-7.0%	81.6%
4-Dec-00	Kingmaker	53.2%	-17.1%	113.7%
3-Dec-01	Tungtex	56.3%	-7.9%
	3-year compound	195.2%	-29.1%
	Compound average	43.5%	-10.8%

If you put $1,000 into the first pick, and rotated into the next one each year, you would have about $2,952 now. By comparison, if you invested in the Hang Seng Index 3 years ago, you'd have about $709. So our picks have out-performed the index by 316%.

This year's Pick

OK, we seem to be getting the hang of this. So let's try and make it four in a row...

This year, our far-sighted stocking-filler is Arts Optical International Holdings Ltd (Arts Optical, 1120). The company makes and sells spectacle frames. It has a well-balanced distribution, with around 40% of its sales to Europe, 40% to the USA and the rest to Asia and other regions.

Share capital

Arts Optical was listed on 8-Nov-96 and has 374.41m shares in issue, with a market cap of HK$700.1m at yesterday's closing price of HK$1.87.

The Chairman, Michael Ng Hoi Ying, owns 40.55%, his wife owns 9.80%, and his brother, Ng Kim Ying, who is also on the board, owns 4.98%. Including Finance Director Desmond Lee Wai Chung's 0.27%, the total insiders' holding is about 55.60%. At 30-Jun-02, there were total options outstanding over 13.45m shares exercisable pursuant to an unpublished vesting scale between 7-Jul-00 and 23-Oct-06 at $0.88 per share.

On 12-Jan-02 Templeton Strategic Emerging Markets Fund LDC (Templeton) agreed to purchase 28.5m shares from Ng Kim Ying, who in turn subscribed for 18.5m new shares, making a net sale of 10m shares at $1.70 per share. As a result, Templeton owned 29.39m shares or 7.90% of the enlarged issued share capital. That's below the 10% disclosure threshold, so we don't know what their holding is now.

Track record

As shown in the 5-year track record, the company, which has a December year-end, showed steady growth until 2000, but had a difficult year in 2001 with net profits down 15.8%, partly due to the effects of the 9-11 events. In the first half of this year, sales grew 5.7%, gross profit increased, but higher administrative costs reduced net profits 20.1%. A full enterprise resource planning (ERP) system came on line in Jan-02.

Arts Optical operates a retail chain in China under two brands, "Arts 1000" and "Sunny Arts", with a total of 63 stores as of 30-Jun-02, up from 42 stores at the year end. This had "not yet generated any significant contribution" to the group, but with the number of stores set to reach 100 in the next few months, breakeven is on the horizon, and this represents a play on the increasingly affluent Chinese consumer.

Balance sheet

Arts Optical has a strong balance sheet with net tangible assets of $1.50 per share at 30-Jun-02, and net cash of about $0.56 per share.

Corporate Governance

Since its listing six years ago, the company has not had any notable corporate governance problems. It has only 3 executive directors - the Chairman, his brother, and the Finance Director. The board could do with more breadth in this respect.

It also has two independent non-executive directors (the minimum required by the Listing Rules). One, Frank Martin, has served since the IPO, has been President of the American Chamber of Commerce in HK since 1990 and is a former CEO of Security Pacific Asian Bank. The other is Alex Kwong Kam Kwan, a qualified accountant, who joined Arts Optical in 2001 to replace a deceased INED who had served since the IPO.

The company has largely kept its nose clean and did not get sucked into the property or dot-com bubbles, but did show listed HK equity holdings of HK$4.6m in its 2001 balance sheet, although these were sold by 30-Jun-02. We gave them a message at the AGM: let's stick to what we're good at: we'll do the investing, and you make the spectacles.

Outlook

Arts Optical is expected to earn around $0.26 per share for 2002, putting the stock on an undemanding current-year P/E of 7.2x. However, if you strip out the net cash then the core P/E for the underlying business is about 5.1x.

Despite the fall in interim profits, the company sent a positive message by maintaining its interim dividend at the same level as last year, and given the ample cash reserves, we expect this practice to continue. The historic yield is now 8.6%. Earnings growth in the next year or two should come from a consumer recovery in the US and Europe, and expansion of the Chinese retail operation.

So there you have it. If you put your specs on and look hard enough in Hong Kong's minefield of fraud, rip-offs and bad governance, you can find little nuggets of value with clean track records. Arts Optical is our 2002 Christmas pick.

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The 2002 Christmas Pick 4 December 2002